A new paper drawn from the “Core-Satellite and ETF Investment” research chair at EDHEC-Risk Institute, sponsored by Amundi, examines the ways dynamic
asset allocation techniques can be used to manage portfolios of exchange-traded funds (ETFs).

First, dynamic allocation to stock and bond ETFs and traditional static diversification are compared. Second, tactical allocation to stock and bond
ETFs and risk-controlled allocation—with both forms of allocation informed by the same return forecasts—are compared. The paper shows that dynamic asset
allocation techniques that can be used with frequently traded and broadly diversified instruments such as ETFs make it possible better to address investor concerns over drawdown and intra-horizon risk, whether or not the manager wishes to make return predictions.

The asset management industry has traditionally focused largely on security
selection. Following the evidence of the importance of asset allocation (Brinson et al. 1986), the industry has paid increasing attention to passive investment vehicles that provide exposure to broadly diversified baskets of securities. Such vehicles make security selection unnecessary and allow asset managers to concentrate on allocation to different asset classes or styles.

Asset managers have two main means of using asset allocation to add value. The first is strategic asset allocation, in which the goal is to diversify the asset mix so as to obtain the best possible risk/return tradeoff for investors. Strategic allocation depends mainly on the correlation of the returns of different asset classes and on the risk premia of these asset classes. The challenge is to estimate these parameters. In addition, correlations and risk premia are not necessarily stable. In particular, diversification often fails when it is most needed, as correlation increases during crises (Longin and Solnik 2001).

The second means is tactical allocation, which relies on predicting the short-term returns on different asset classes. Managers can then increase exposure to high-return asset classes and decrease exposure to low-return asset classes. The primary aim of tactical allocation is often outperformance rather than risk management.

Asset managers are relying more and more on ETFs to implement these strategies. The volume of assets invested in these funds has increased more than five-fold in the past six years, both in Europe and in the United States (Deutsche Bank 2009). Miffre (2007) and Hlawitschka and Tucker (2008) empirically assess the potential diversification afforded by holding more than one ETF. Amenc et al. (2003) and de Freitas and Barker (2006) analyse tactical
allocations to ETFs on different asset classes and styles.

The objective of this new paper is to analyse portfolios of ETFs that go beyond these traditional diversification and tactical allocation concepts. Rather than focusing on diversification alone, we apply dynamic risk management techniques that take into account investors’ aversion to intra-horizon risk. After all, investors are averse not just to end-of-horizon risk but also to negative outcomes within the investment time period (Kritzman and Rich 2002; Bakshi and Panayotovb 2009).

Addressing these concerns requires dynamic risk management. We first analyse how this concept can be used when, in the absence of any views on the returns to these asset classes, decisions to allocate to stocks and to bonds are made. We describe a dynamic risk management technique that makes it possible to provide relatively smooth returns with limited risk, an outcome
similar to that sought by the absolute return funds that have proliferated in
recent years. We then introduce a novel means of using forecasts of asset class
returns to construct dynamic portfolios of stock and bond ETFs.

Rather than using a strategy in which asset class weights depend only on return predictions, we take the dynamic core-satellite approach to act on return predictions—the dynamic risk budget is a given. The aim of the approach is to provide an element of risk control. Expected outperformance of an asset class does not lead directly to changes in weights. Instead, we adjust the multiplier in the dynamic strategy in keeping with the predicted outperformance, thus changing the weights indirectly. We show that, even if the manager is an excellent forecaster, this approach yields risk-control benefits considerably greater than those of standard tactical asset allocation.